Tax Structuring (Part 1)

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Tax Structuring (Part 1)

In this post, we'll be addressing deal structuring from a tax perspective.

But first, a disclaimer. I am not a tax attorney; this post will stay at a high level. If you want to get into the tax weeds, seek out specialist tax advice.

Additionally, and as a reminder, SMB-Transactions is for informational purposes only. Hire a lawyer (me or any other competent lawyer), if you need legal advice with respect to your deal.

Where were we?

How do I optimize my deal from a tax perspective?

Simple: Structure the deal as an asset purchase.

Review my earlier post, Assets or Stock (or Merger)?. An asset deal is generally to the buyer’s advantage; from a tax perspective, the buyer in an asset deal usually receives a stepped-up basis in the acquired assets.

A stepped-up basis is good. It means the buyer can peg the tax basis of the assets (i.e., the value of the assets for tax purposes) at their fair market value at the time of closing.

This stepped-up basis will lead to greater depreciation and amortization deductions, which will lower taxable income in future years. It will also offer you protection against capital gains tax if you later sell the assets (gain being the difference between sales price and tax basis).

Unfortunately, and as also explained in Assets or Stock (or Merger)?, sometimes, you have to structure the deal as an equity deal. For example, certain key contracts may be unassignable.

An equity deal robs you of the tax advantages of an asset deal. The basis in the assets will remain the same post-acquisition; you won’t get that stepped-up basis.

What should I do if I have to structure my deal as an equity deal?

Do not fear. You have options. In fact, you may have nothing to worry about.

It depends on what you’re buying and how.

Let’s look at two common examples.

(1) Limited Liability Company (LLC) taxed as a disregarded entity

If you’re purchasing the equity of an LLC taxed as a disregarded entity, the purchase will nonetheless be treated as an asset purchase for tax purposes.

Let’s understand why.

When it comes to income tax, there’s no such thing as an LLC. Depending on the LLC’s tax elections, and the number of members, the taxman will view the LLC as either a corporation, a partnership, or a disregarded entity.

If the LLC is taxed as a disregarded entity, the taxing authorities will look through the LLC. The taxman will only acknowledge the owner; the owner will report the LLCs income and expenses on her individual return.

For income tax purposes, therefore, purchasing the equity of an LLC taxed as a disregarded entity is akin to purchasing the equity of an individual. And this, you cannot do. So instead, the purchase is treated as an asset purchase.

It’s as if you are purchasing the business’s assets from a sole proprietor, not an LLC.

(2) LLC taxed as a partnership

With some exceptions, only a single-member LLC can be taxed as disregarded entity. In fact, unless the LLC’s sole member elects otherwise, this is the default tax classification for a single-member LLC.

But if there are two or more members, the LLC cannot be taxed as a disregarded entity. Instead, the default tax classification becomes a partnership.

If a sole buyer purchases the equity of an LLC taxed as partnership, that purchase will also be treated as an asset purchase for tax purposes.

Again, let’s understand why.

Partnerships need more than one person. If a sole buyer purchases the equity of an LLC taxed as a partnership, the LLC’s status as a partnership terminates.

At that point, as far as the taxing authorities are concerned, the partnership is deemed to make a liquidating distribution of its assets to its partners. And, immediately following that distribution, the buyer is deemed to purchase the former partnership’s assets.

As a result of this hand waiving, the deal is treated as an asset purchase. The buyer is left with an LLC taxed as disregarded entity.

Just to be clear, we’re only talking about income tax here.

When you organize an LLC, you’ve organized an LLC for legal purposes. With respect to income tax, however, you’re either a corporation, a partnership, or a disregarded entity. You can’t be taxed as an LLC.

Similarly, when you purchase the equity of an LLC, you’ve purchased the equity for legal purposes (​including the liabilities of the business​). You may, however, have purchased the assets for income tax purposes (depending on the circumstances).

What happens if neither of the above scenarios applies to my deal?

Don’t worry, you may still have options. In particular, under certain circumstances, Internal Revenue Code Sections 338(h)(10) and 336(e) permit the parties to treat an equity purchase as if it were an asset purchase for tax purposes.

What are those circumstances? Read Part 2 to find out more.